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Businesses are divided into accounting periods. And in each financial period, the financial statements have to be accurately created. Further, it is crucial to create adjusting entries at the end of each accounting period. Adjusting entries ensures that revenue and expenses are recognized when they occur by updating previously recorded journal entries. In this blog, let’s learn more about the adjusting entry in detail.
Adjusting entries is a significant step of the accounting cycle in every accounting period. It refers to the changes made in the already recorded journal entries. Adjusting entries record any unrecognised income or expenses at the end of the accounting period. So, when a transaction begins and ends with a particular accounting period, it is vital to properly account for each transaction. Plus, it results in accounting accuracy and remains up-to-date.
Adjusting entries also means financial reporting that rectifies an error in the previous fiscal year. The major objective of the adjusting journal entries is to change cash transactions to an accrual accounting method. So, what is accrual accounting? It depends on the revenue recognition principle that identifies revenue earned in that specific period rather than the period where cash was received.
Adjusting journal entries can be understood better with an example. Take, for example, a landscaping business, assume that the company started the work and didn’t invoice the customer for over 6 months till the completion of work. At the end of each month, the construction company must make an adjusting journal entry to acknowledge revenue equivalent to 1/6 of the total amount to be invoiced after the six-month period.
Adjusting entries consists of the income statement account (profit or expense) together with a balance sheet account(asset or liability). Generally, it pertains to balance sheet accounts such as accumulated depreciation, allowance for doubtful accounts, accrued expenses, accrued income, prepaid expenses, deferred revenue, and unearned revenue.
Some of the income statement accounts that need to be adjusted include interest expense, insurance expense, depreciation expense, and revenue. All the entries are made on the basis of the matching principle to match expenses to the relevant revenue in the same fiscal year. So as the adjustments are made in the journal entries, it is later carried over to the General Ledger which then flows to the financial statements.
Also Read : The Role of Journal Entries in Accounting
Before tallying at the end of the accounting period, it is vital to understand the purpose of adjusting entries. The major importance is that it is hugely helpful in tracking all the receivables and payables. Further, it helps in identifying all the profit or loss in every financial year.
If the financial statement is taken without adjusting journal entries, then the financial health of the business is affected. The net income and owner’s equity will be exaggerated, while expenses and liabilities will be understated. To avoid such scenarios, using adjusting journal entries and accrual basis is pivotal.
Finally, an adjusting entry is crucial for depreciating assets as it will be useful for reporting tax deductions and balancing the book at the end of an accounting period.
In total, there are three types of adjusting journal entries – Accrual, Deferral and Non-Cash expenses.
In this type, a business can earn revenue in a particular financial year from selling its goods and services without invoicing the customer or accept payment until the future accounting period. All these earned revenues are recorded as adjusting journal entries which can be identified as Accrued revenues.
The accrued revenues can be recorded by debiting the accounts receivable and crediting the service revenue account.
The other variant of accrual is the accrual expense. It is expenses made by the business which are not paid yet, such as salaries or interest expenses. Adjusting entry records it as debiting the expense account and crediting accounts payable.
If your business incurs an expense that will provide benefits across multiple accounting periods, like paying upfront insurance for the entire year, it is recorded as a prepaid expense. All the prepayments are first documented as assets but later on, they are expensed through adjusting entries. For prepaid expenses, the adjusting journal entry includes a debit to the expense account(e.g. insurance expense) and previously recorded credit to the prepaid expense account.
Deferral revenue is an adjusting entry that converts liability to value. Plus, it is the revenue a customer pays for the business for the services which are not delivered yet. It can be in the form of subscriptions, yearly memberships etc.
Once cash is received from the customer, it is initially recorded as a liability as it has not yet been earned by the business. As time progresses, this liability is gradually transformed into revenue until it is fully recognized as earned.
This change can be done by debiting the unearned revenue accounting and crediting the service revenue account.
In order to adjust non-cash expenses, the most common method used is depreciation. Depreciation means spreading out the cost of a depreciable asset over its useful lifespan. It is also known as fixed assets, the physical assets a company owns, which can last for more than one accounting period. Equipment, furniture, buildings etc. are examples of fixed assets.
The adjusting entries to record the depreciation expense include a debit to the depreciation expense account and a credit to the accumulated depreciation account. Some of the other methods to adjust non-cash expenses are amortization, stock-based compensation, depletion etc.
This is an adjusting journal entry that records non-cash expenses such as allowance for doubtful accounts, depreciation expense or the inventory obsolescence reserve.
Manual creation of adjusting entries is tedious and error-prone. Automating adjusting entries with cloud accounting software will promote more accurate entries–
Adjusting journal entries are recorded in the journal entries to match the expenses and revenues of an accounting period. The three major types of adjusting journal entries are accrual, deferral and non-cash expenses. Leveraging ERP software can help the adjusting entries to be done faster.
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